Buy, Sell or Hold: Chesapeake Energy Corp.

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To say that trading energy stocks has been difficult in recent months is a major understatement. When you see that even an industry giant like Chesapeake Energy Corp. (NYSE: CHK) lost money in its hedging activities, you know that trading activity during that quarter was extremely wild.

At Friday's closing price of $48.40, Chesapeake Energy shares are down 35% from their 12-month high of $74. But the cause is clear.

When crude oil shot up from about $100 per barrel to $135 per barrel a few months ago – and natural gas skyrocketed from $10 per billion cubic feet (bcf) to $13.50 per billion cubic feet at the same time, prompting all sorts of investigations into speculative activities by the Commodity Futures Trading Commission, and in turn prompting calls for Congress to make it harder for financial investors to buy energy futures – it's no surprise to see that almost every energy producer that prudently hedges part of its production against price drops had losses in the quarter.

Most analysts – myself included – are asking: "If we would have started drilling in the Continental Shelf and other such places a while ago, would this have ever happened? Probably not." But it did. When the market supply-demand equation gets tight for any critical resource, prices have a way of getting totally out of hand. And lack of flexibility in supply is always to be blamed. In this case, it seems as if Chesapeake Energy was caught badly on the "wrong" side of the trade. Or was it?

As Chesapeake was selling natural gas futures, and as those futures were climbing exponentially, the company was taking what looked to be huge mark-to-market losses. But natural gas prices peaked shortly after June 30 and have collapsed with the demand destruction that has prompted a quick reversal in investor positions from "long" to "short."

This brought prices down to their strong support levels of around $8 per bcf. These much lower levels were pretty stable for all of 2006 and 2007. So it turns out that Chesapeake was actually prudent in its strategy of taking advantage of high natural gas prices while it had the chance to do so. And its chief executive officer was confident enough that he was willing to take the heat over lackluster quarterly earnings for this huge temporary mark-to market hit and was not squeezed into closing these "losing positions" and realizing the loss. He took the bad mark-to-market hit at the quarter's end and all the heat that this implied.

But do not let this quarterly loss fool you. In fact, the staggering $1.6 billion loss had, by July 25, reversed and moved up the value of Chesapeake hedges by a gorgeous $4.7 billion. CEO Aubrey K. McClendon and his team had seen what was coming and masterfully called the market's bluff.
With Chesapeake's staggering reported loss for the quarter and with natural gas prices now down to pre-bubble levels, the "fluff" in the stock has been removed.

Are the shares now worth a shot? You bet.

Not only is natural gas a key part of the energy solution for this energy-starved country, but Chesapeake's long-term strategy is to tap into a very clean form of energy that is abundant in the U.S. market and to lead production in North America. Natural gas and oil sales almost doubled from a year earlier to about $2.2 billion, showing an operating gain of $479 million, which beat Wall Street estimates by a penny. What's more, at these prices, you are already seeing strong incentives to switch some energy generation away from coal, whose prices have remained stronger, to natural gas-fired plants.

And Chesapeake is growing its reserves at about a 20% to 21% annual clip thanks to its expanding production in The Barnet, Haynesville Fayetteville and Marcellus Shale areas. This is the key to future share price growth. The shale production revolution, enabled by newer and cheaper drilling technologies and current prices of natural gas, is changing the industry, allowing for sustained reserve growth. And that will help satisfy the ever-expanding demand.

So you are buying Chesapeake at levels that now reflect the much lower prices we are seeing today in natural gas – but at a time when we are heading into the heating season, and we are counting on continued reserve growth from their shale strategy to keep growing the bottom line. What about the volatility in earnings due to hedges? It is just loud market "noise" that proved that the company really knows the market and that has provided you with this great buying opportunity.

[Editor's Note: Horacio Marquez was working as a vice president of the Merrill Lynch Emerging Markets Fixed Income Group in 1994 when he correctly predicted that both Argentina and Mexico were headed for currency crises – cementing his reputation as an expert on both the emerging markets and on the nuances of global finance. Now Marquez brings that expertise to you with his newly created "Shadow Stock Trader" service. To find out how to subscribe, please click here. "Buy, Sell or Hold" is a brand-new Money Morning feature most recently analyzed Berkshire Hathaway Inc. (NYSE: BRK.A, BRK.B). It also has covered such companies as Cisco Systems Inc. (Nasdaq: CS), ABB Ltd (NYSE ADR: ABB), Cummins Inc. (NYSE: CMI), Chevron Corp. (NYSE: CVX), Valero Energy Corp. (NYSE: VLO), and General Electric Co. (NYSE: GE). Over the next several Mondays here in Money Morning, we'll be reviewing Chesapeake Energy Corp. (CHK), and will take a look back at some of our previously featured stocks.]

I like CHK — but i also like to use stops. Fundamental analysis is great, but now that the stock is 17 instead of 48, unless somthing has changed in the long term, i would think that NOW is really the buy zone. I would be interested in Horatio's take now, for new buyers, and others who may wish to add to their positions. Thanks for a great service – Bill

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